Many of our clients are receiving Form 1099s from creditors reporting income to the Internal Revenue Service. This “income” is actually debt the creditor forgave or wrote off, and to the IRS, this forgiveness of debt is considered taxable income just as if you had earned wages from employment. Receiving the 1099 can be potentially harmful if you do nothing to respond, but there are some exceptions that can help you avoid the tax liability.
The first exception is that if the debt was discharged in bankruptcy it is not taxable income. This is an important advantage that bankruptcy provides over debt settlement programs and negotiated agreements to write off debt. If you receive a 1099 for debt that was discharged in bankruptcy, ask your tax accountant to file a Form 982 along with your tax returns. The form will notify the IRS that a bankruptcy was filed and the discharged debt is not taxable.
The second exception is when the debtor is insolvent immediately before the debt was forgiven. The forgiven debt is tax free to the extent of the insolvency. In other words, if your debts exceed the fair market value of your assets by $20,000 you can have up to $20,000 of debt forgiven tax free. You’ll again need to have your tax accountant file Form 982 with your tax returns to avoid having the forgiven debt treated as income.
The last exception is that only the forgiveness of principle is treated as income so writing off accrued interest should not be taxable. There are also some special rules related to farmers when debt is forgiven so if you’re a farmer and have debt forgiven be sure to consult with a tax accountant.
For all debtors, if you’re facing the forgiveness of debt be sure to consult with an attorney about what tax liabilities you might face if this write off occurs outside bankruptcy.